As the market revives, a number of ongoing concerns — which until the onset of the COVID-19 outbreak and subsequent lockdowns had rumbled on in the background of the direct lending market — have been brought into the spotlight for money managers and institutional investors: the strength of deal covenants and the degree to which a portfolio company is leveraged.
"There has been a lot of dry powder with a lot of new funds and new entrants raising capital, which ended up chasing the same deals," said Thibault Sandret, a director on consultant bfinance U.K. Ltd.'s private markets team in London. "As a result of this competition, we have seen in recent years a deterioration in the risk-reward equation," with a compression in spreads and "a loosening of underwriting standards" in some cases.
Added to that is the trend across the globe for companies to adjust earnings before interest, taxes, depreciation and amortization or use add-backs, with fears among sources that deals are being overleveraged because of these figures. "When the economy and the debt come under pressure, you end up with companies in your portfolio that have a higher level of debt than if you had been a bit more disciplined," Mr. Thibault said.
Weaker covenants have been a global issue.
"Aggressive issuer-friendly terms were indeed features of the bull loan market that ended in early March," said Randy Schwimmer, New York-based senior managing director, head of origination and capital markets at Churchill Asset Management LLC — an investment specialist of Nuveen LLC — which has $24 billion in committed capital across direct lending and private equity funds. Executives in the direct lending team avoided covenant-light structures as a result of their experience during the last downturn.
"Not having performance triggers in the credit agreement deprives you of a critical tool to protect loan value. Having them in the current environment has been extremely beneficial," Mr. Schwimmer said.
However, the pandemic may help to strengthen covenants.
"The value of the financial covenant will be proven in this cycle, and the tolerance to entertain covenant-light in the middle market will be much lower post-crisis than it was before," said Taylor Boswell, New York-based CIO of Carlyle Group Inc.'s direct lending business, part of the firm's global credit platform. The firm has about $5 billion in direct lending assets under management. "But fully levered, covenant-light middle-market deals were really just emerging in the last 12 months, so they'll likely be nipped in the bud by the crisis," Mr. Boswell said.
Every time a borrower calls a lender to the table for help, they can claw back some terms to add protection to an existing deal, sources said.
"The topic people will be wondering about now is how much of that degradation will be recovered. And it's fair to say that in the current market lenders are recapturing a significant amount of the terms and covenant degradation that occurred over the course of the last cycle, both in new deals and through amendment activity," Mr. Boswell said.
Strong relationships with borrowers mean that "each time they come back to the table … (lenders) have an opportunity to improve documentation. So those financial covenants prove valuable in remedying weaknesses that may have crept in over the course of the cycle," he added.
But sources said their concerns are also being exacerbated by the structure of more recent deals.
"The unitranche lenders are now in a situation where … they've done highly levered structures and gone deeper down the capital structure," said Patrick Marshall, head of private debt and collateralized loan obligations at Federated Hermes Inc. in London. "That was fine if you did a loan with 30% equity before the crisis, but … that equity cushion has evaporated. And they've lent aggressively based on EBITDA add-backs. So they have high leverage, low equity buffers and many (of the portfolio companies) are cyclical businesses."
Those elements "in effect mean businesses are in far more trouble by the time a covenant is triggered," Mr. Marshall said. The firm — which does not split out direct lending assets, but has $4.1 billion in fixed-income strategies for the international business — takes a lower-risk, "conservative" approach, lending alongside banks and refusing to negotiate on loan terms in order to keep investors protected.
Deal structure is one of the biggest contributing factors to performance, said Leander Christofides, London-based co-CIO of J.P. Morgan Asset Management's global special situations team, which offers private debt expertise to institutional clients.
"As the market became more competitive … the value cushion" within structures has lessened, with moves toward unitranche deals, Mr. Christofides said. "From a distressed perspective it means a company is more likely to default, and when it does because there is no value cushion below you, recoveries are lower. We have seen that in recent data."
Mr. Christofides said recoveries a few months ago neared 60%. Today, loans that have defaulted are recovering at about 45%. "You can see this concept of a unitranche and no structural cushion below you has a real impact on recoveries."